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  • Stocks have rallied this month.
  • S&P 500 earnings are expected to have fallen 4.6% in Q4.
  • How stocks react to earnings reports is key.

The stock market has enjoyed a resurgence since the S&P 500 made its monthly low on December 22. The strength has been widespread, with many of 2022’s biggest losers posting remarkable gains. Whether or not the rally fizzles may depend on what companies say during fourth-quarter earnings conference calls, which begin in earnest this week.

In last week’s podcast (link here), Action Alerts PLUS’ Portfolio Manager, Chris Versace, asked me what earnings reports I’m watching this season. My response was that I’m far more interested in how investors react to earnings this quarter than the individual numbers reported by the companies. Why? Because the reaction will offer insight into bullish and bearish sentiment. If stocks report lackluster results, yet shares rally, it adds conviction that worry over declining earnings is already priced into stocks. If not, stocks may struggle.

Plenty of reasons to worry

Stocks performed terribly last year because the Federal Reserve’s rapid series of rate increases reset valuation multiples, and sky-high inflation squeezed corporate earnings.

Rising rates devalued future cash flow in investors’ models, resulting in lower price-to-earnings ratios. Meanwhile, higher input costs reduced operating margin, negatively impacting earnings. Of course, it didn’t help that a strong U.S. Dollar negatively impacted currency conversion on foreign sales, nor did shifting spending trends from higher-margin discretionary purchases to necessities because of negative real wages offer support.

The result was a sharp drop in earnings and a reset in analysts’ earnings outlooks. 

Wall Street expects fourth-quarter 2022 S&P 500 earnings to fall 4.6% from the previous year, the first year-over-year contraction since the third quarter of 2020 when COVID lockdowns impacted economic activity, according to FactSet. On December 31, estimates were for a -3.2% decline, and analysts expected the decline to be -2.3% as recently as mid-November.

The first and second-quarter outlooks are better but still bad. Analysts expect S&P 500 earnings to decline by -1.1% and -1.2% in the quarters, respectively, from one year ago. The lone bright spot is that earnings are expected to rebound in the second half of 2023, resulting in full-year growth of 4.2%.

Unfortunately, like Q4 estimates fell in the wake of third-quarter results, first and second-quarter outlooks could slip if companies generally report disappointing fourth-quarter earnings.

Stocks discount the future

Stocks are a leading indicator. They rally and fall before changes in economic activity.

The fact that stocks have gained ground recently is encouraging that, perhaps, the worst is behind us. 

Real Money’s James DePorre writes, “The bullish hope [is] that the Fed has already won the battle against inflation and will be able to engineer a soft economic landing that prevents stocks from falling into another downtrend…The bulls are hoping that there is still too much negative positioning and that some OK reports will force those on the sidelines to start climbing the wall of worry.”

However, that’s still largely guesswork because it remains to be seen if, in the aggregate, that’s how investors react. After all, there’s still a reasonable argument to be bearish. 

DePorre writes:

“The question of the day is whether these earnings are going to be the signal that another down leg is coming. The indexes have become a bit extended, and sentiment a bit frothy, which is a good setup for a "sell the news" reaction. The consensus view among market strategists is that stocks will suffer another substantial pullback or two before the miserable bear market comes to an end. The theory is that concerns about inflation and slowing economic growth will produce some struggles as market participants try to fully discount the obstacles that lie ahead.”

It’s still too soon to know if bulls or bears will regain control of the field, but we’ll have a much better idea in a couple of weeks once most companies have reported their results and offered up insight into current business conditions during their quarterly conference calls.

So far, there’s some reason for encouragement. Stocks have held up pretty well despite the initial slate of earnings reports issued last week being arguably poor.

Back to DePorre:

“To date, the ratio of earnings reports that have beat Wall Street consensus views has been extremely poor. Typically about 70-80% of companies will beat consensus EPS estimates, but this quarter the ratio is under 50% so far.”

Yet, key stocks that have reported results are doing better than you might expect, particularly the big banks, which are among the first to release earnings. For example, Bank of America  (BAC) , JP Morgan  (JPM) , Wells Fargo  (WFC) , Citigroup  (C) , and Morgan Stanley  (MS)  have largely either held their ground or rallied after their reports. Not many growth stocks have reported numbers yet, but Netflix  (NFLX)  has, and despite tepid 2% year-over-year revenue growth and a sharp decline in year-over-year EPS growth, its shares are up 14%.

The Smart Play

The sample size is too small for us to draw any conclusions yet, but the pace of reports is accelerating, and we’ll get updates from hundreds of companies this week and again next week.

How investors react to reports from discretionary stocks, such as retailers and restaurants, and technology stocks will be most intriguing, given they’re early cycle baskets that do best when the economy is recovering rather than deteriorating.

I’m curious how investors react to earnings reports from the biggest growth stocks, including Microsoft  (MSFT) , which reports after the bell today.

Big-cap technology companies have seen share prices fall significantly in the past year yet remain heavily weighted within the S&P 500 index. If investors emerge from reports as optimistic, then the S&P 500 will have an easier time staying above its recently recaptured 200-day moving average. If not, then weakness in technology stocks will make doing that much more difficult. For perspective, Microsoft is the S&P 500’s second-largest position with a 5.5% weighting as of December 31, and the information technology sector, despite last year’s sell-off, still comprises 26% of the S&P 500 ETF.

I’m also curious how investors react to reports from battleground stocks, including Tesla  (TSLA) , which reports earnings on Wednesday (I discussed this point on this week’s Action Alerts PLUS podcast). Tesla is one of the market’s most loved and hated companies, so how it trades after reporting its results may provide insight into if bulls or bears are still in charge.

Overall, there’s little debate about whether earnings are declining (they are). Instead, it’s about how much current share prices reflect that decline. For this reason, the reaction to results is more important than the results themselves during this earnings season.

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